How Do Interest Rates Work in Canada?

When it comes to interest rates, think of it as the price someone pays to borrow money. After all, nothing in life is truly free. When you take out a loan and interest is charged, you’ll end up repaying more than you borrowed. On the other hand, when you put money into a savings account, the bank pays you interest for the privilege of using your money, meaning you’ll receive more money than you put in.

So how does the money make money? Maybe you’ve read about how to pay off your credit debt and how to pick the perfect savings account. Both are matters of looking at interest rates and your financial goals. But, interest...how does it work? And how do interest rates affect your financial health?

So, how do interest rates work exactly?

The interest rate is basically the fee a lender charges you for borrowing money, and it’s calculated as a percentage of the loan amount or principal. This rate is usually stated annually and is known as the annual percentage rate (APR).

Interest rates also apply to savings accounts and investment products. And while they can apply to a chequing account, it’s much less common. Here, a bank or credit union pays you a percentage of your deposited funds. The term annual percentage yield (APY) is used to describe the interest you earn on these accounts.

When you borrow money, interest rates apply to various loans like credit cards, personal loans, student loans, and mortgages. On the flip side, you earn interest when you open a savings account or investment product, like guaranteed investment certificates (GICs), mutual funds, or registered retirement savings plans (RRSPs).

What is annual percentage rate (APR)?

The annual percentage rate (APR) is the yearly interest charged to borrowers or paid to investors. Expressed as a percentage, APR represents the actual yearly cost of a loan or the income earned from an investment, including any fees or additional costs. However, because it only accounts for simple interest, it doesn’t account for compounding interest (which we talk more about below!). APR gives consumers a clear number to compare when looking at different loans, credit cards, or investment products.

What is annual percentage yield (APY)?

Annual percentage yield (APY) is the effective annual rate of return, factoring in the impact of compound interest. By looking at the APY, you can compare different savings accounts to see which one will give you the best return on your money. This is particularly useful when accounts have different interest rates and compounding frequencies.

Simple vs. compound interest

There are two ways interest rates can be calculated on a savings account.

Simple interest is calculated as a percentage of the principal over time. However, compound interest, which is more common, includes both the principal and the interest that has already been earned or charged. Most loans and savings accounts use compound interest.

Simple interest is calculated only on the initial amount you deposit, while compound interest is calculated on both your original deposit and the interest that has already been added, helping your savings or investments grow faster over time.

Simple interest

Simple interest is paid only on the initial amount you deposit into a savings account. To figure it out, you multiply your deposit by the interest rate and the time period. For instance, if you put $1,000 into a savings account with a 5% annual interest rate, you’d earn $50 in interest after one year (1,000 x 0.05 x 1).

Simple interest is straightforward to calculate and understand, but it doesn’t account for the time value of money, making it less ideal for long-term investments.

Compound interest

Compound interest, on the other hand, is calculated on both the principal and the interest that has already been earned, which helps your savings grow faster over time. This means that both your original deposit and the accumulated interest earn more interest. The more frequently interest is compounded, the more your savings will increase.

The real power of compound interest is seen through “interest on interest.” Over time, this compounding effect can lead to significant growth in your savings, especially if you keep making regular deposits.

What is the difference between a fixed interest rate and a variable interest rate?

Fixed-rate mortgages are exactly what they sound like—fixed. Your loan’s interest rate stays the same for the entire term of your mortgage.

This means that no matter how prime interest rates move up or down, your mortgage rate remains locked in. Your payments will also stay the same, giving you a predictable schedule. If you want stability and predictability in your mortgage, a fixed-rate mortgage might be the right choice for you.

On the other hand, variable interest rates mean you don’t have a fixed rate for the term of your loan. Instead, they fluctuate based on the bank’s prime rate, which is influenced by changes in the Bank of Canada’s overnight rates.

With a variable-rate loan, your regular payments stay the same, but the portion going toward interest can change. If interest rates go up, more of your monthly payments will go toward interest, potentially extending your amortization period.

What does the Bank of Canada have to do with interest rates in Canada?

The Bank of Canada is a crown corporation, meaning it’s owned by Canadians (yes, that’s us!). Even though it technically belongs to the Federal Government, it operates independently from our elected officials. This independence helps protect our economy and financial system from political interference.

The Bank of Canada’s job is to regulate and monitor the Canadian financial system and keep inflation stable and low, ensuring our economy can grow. It also acts as a research institution, studying various factors that impact the value of Canadian money and setting the policy interest rate.

As of July 2024, the Bank of Canada’s interest rate is 4.50%.

Typically, the Bank of Canada adjusts the policy interest rate on eight predetermined dates throughout the year. When the Bank of Canada decides to make an unannounced change, like in March 2020, it can feel scary and confusing. It’s normal to feel anxiety when things change suddenly. In general, the Bank of Canada is acting to create a sense of long-term economic stability for Canadians.

Policy interest rate

This is a bit complicated, but here’s the gist: the Bank of Canada’s interest rate, also known as the 'Overnight Rate,’ is the interest rate that major Canadian banks charge each other for overnight loans.

Let’s break it down. Big Canadian banks need to handle a lot of daily transactions for their customers, including individuals, businesses, and investment funds. To manage these transactions, they need access to large amounts of money that can change quickly. So, they lend each other large sums of money overnight and repay it the next day. This process is known as the overnight market.

The overnight rate, or policy interest rate, is the interest rate on these overnight loans between major banks.

How that affects you

When the Bank of Canada changes the overnight rate, it affects how commercial banks set interest rates on loans and savings products. These include credit cards, mortgages, lines of credit, and high-interest savings accounts.

When the policy interest rate is lowered, banks usually adjust their interest rates both for the money they lend out and the interest they pay on savings and investments.

Generally, a change in the Bank of Canada’s policy interest rate triggers a chain reaction that impacts lending rates at every bank. Each bank sets its own “prime lending rate,” which is heavily influenced by the Bank of Canada’s rate. Each commercial bank uses its prime rate as the building block for many different lending services. But you probably, like most consumers, think of the prime rate as being significant to mortgages specifically.

When interest rates drop, as they did after COVID-19 in 2020 or the subprime mortgage crash in 2008, it generally makes borrowing cheaper and saving less rewarding.

For example, if you have a variable-rate mortgage, a lower interest rate means you’ll pay less interest. The same goes for a Home Equity Line of Credit.

A lower policy interest rate usually means banks will lower their prime rates on mortgages. So, if you’re thinking of buying property, it’s a good idea to do so when rates are low because it can help you pass a mortgage stress test more easily.

However, lower rates can also mean your savings earn less. If you’re retired or living on a fixed income from a savings fund, this can be a bit tough. Investments with guaranteed interest, like GICs or high-interest savings accounts, will see a lower return.

On the bright side, if you own property, the reduced mortgage rate can help maintain or increase its value by stimulating market demand.

How do rising interest rates affect you?

We just explained how a lower interest rate can mean you’ll likely pay less interest, which can be great when paying back loans. However, a lower rate can also mean you’ll earn less interest on your savings and investment accounts.

Now, let’s take a look at what rising interest rates mean for you.

Loans become more expensive

At a basic level, this means taking on debt becomes more expensive. If you've locked in a low interest rate on a 5-year mortgage, always pay off your credit card in full, and haven’t needed a new car for a few years, you don’t have to worry about expensive debt right now.

However, this isn’t the case for everyone. Many people rely on various loans, like mortgage, auto, student, or personal loans, to achieve their personal finance goals. When interest rates are low, it’s easier for people to buy homes, cars, and boats and to afford further education and other ambitions because borrowing is cheaper.

So when interest rates rise, that means all those things become more expensive and more difficult to afford.

Saving becomes more attractive

On the flip side, higher interest rates make saving money more appealing. When interest rates are low, there’s little incentive to save. If you can’t earn much by keeping your money in the bank and borrowing is cheap, you might as well spend or invest it in real estate or the stock market. But when interest rates rise, this situation reverses. As a result, people tend to spend less and save more.

For example, back when rates were low, you might have only earned 0.5% on your savings if you were lucky. Now, with a high-yield savings account, you could get double, triple, or even higher than that.

Like with KOHO, you can earn up to 5% interest on your entire balance, making it one of the best high-interest savings accounts on the market. Plus, with KOHO, you can also earn cashback on all purchases made with your virtual credit card, and you can even monitor your credit score for free.

What other factors affect the way commercial banks do interest?

Commercial banks set interest rates for both credit and savings products in a way that sets the bank up to turn a profit. This is why the rate of interest a bank pays you on a savings account is likely to be lower than the interest rate that the same bank collects from you on a line of credit. (This also might explain why many commercial banks are often trying to maintain minimum account balances, get you to pay various kinds of account fees, and sell you more credit…)

The Bank of Canada’s policy rate is one of the major external forces that commercial banks use to determine how interest is set.

Other major external factors include things like:

• What the bank has in assets—if it has extended more credit than it can reasonably cover, for example.

• The price value of those assets—for example, does the mortgage on a property match the current price valuation of that property?

• The global currency exchange rates, or the strength of the Canadian dollar.

• The expectations commercial banks and consumers have about the economic growth outlook. Like a vibe check, but with spreadsheets.

The bottom line

An interest rate is the cost of borrowing money for the borrower and the rate of return for the lender. When you take out a loan, you pay extra as compensation to the lender. Similarly, when you deposit money in a savings account, the bank rewards you with interest because it can use your money to issue more loans.

Interest rates can be complex and confusing, but here’s the gist: if you’re a borrower, high interest rates mean higher monthly payments. This makes borrowing money to buy things like a house or a car more expensive. It’s always a good idea to shop around and compare interest rates, whether you’re looking for a loan or a place to save your money.